Corporate Finance

Members of the NBER's Corporate Finance Program met in Cambridge November 16. Research Associates David Sraer of University of California, Berkeley, and Philip Strahan of Boston College organized the meeting. These researchers' papers were presented and discussed:

Anil K. Kashyap, University of Chicago and NBER; Natalia Kovrijnykh, Arizona State University; Jian Li, University of Chicago; and Anna Pavlova, London Business School

Kashyap, Kovrijnykh, Li, and Pavlova study the impact of evaluating the performance of asset managers relative to a benchmark portfolio on firms' investment, merger and IPO decisions. They introduce asset managers into an otherwise standard asset pricing model and show that firms that are part of the benchmark are effectively subsidized by the asset managers. This "benchmark inclusion subsidy" arises because asset managers have incentives to hold some of the equity of firms in the benchmark regardless of the risk characteristics of these firms. Contrary to what is usually taught in corporate finance, the researchers show that the value of an investment project is not governed solely by its own cash-flow risk. Instead, because of the benchmark inclusion subsidy, a firm inside the benchmark would accept some projects that an identical one outside the benchmark would decline. The two types of firms' incentives to undertake mergers or spinoffs also differ and the presence of the subsidy can alter a decision to take a firm public. The researchers show that the higher the cash-flow risk of an investment, the larger the benchmark inclusion subsidy, the subsidy is zero for safe projects. Benchmarking also leads fundamental firm-level cashflow correlations to rise. The researchers review a host of empirical evidence that is consistent with the implications of the model.

How do restrictions on banking competition affect credit provision and economic output? And, how do they affect financial stability? To identify the causal effect of banking competition, Carlson, Correia, and Luck exploit a peculiarity of bank capital regulation in the National Banking Era: opening banks in towns with more than 6,000 inhabitants required twice the equity as in towns below this threshold, thus leading to a locally exogenous variation of entry barriers. The researchers construct a novel comprehensive data set comprising the annual balance sheets of all national banks, and link it with the results of the decennial census. They show that initially, banks in markets with lower entry barriers extended more credit and chose a higher leverage, leading to a local credit boom that was associated with an expansion in the local manufacturing industry. However, banks in markets with lower entry barriers were also more likely to default or go out of business during or soon after a major financial crisis, the Panic of 1893. The evidence suggests that banking competition supports economic growth by inducing credit provision, but may increase the risk of financial instability by increasing bank risk-taking.

Pengjie Gao, University of Notre Dame and Chang Joo Lee and Dermot Murphy, University of Illinois at Chicago

Gao, Lee, and Murphy examine how local newspaper closures affect public finance outcomes for local governments. Following a newspaper closure, municipal borrowing costs increase by 5 to 11 basis points, costing the municipality an additional $650 thousand per issue. This effect is causal and not driven by underlying economic conditions. The loss of government monitoring resulting from a closure is associated with higher government wages and deficits, and increased likelihoods of costly advance refundings and negotiated sales. Overall, the results indicate that local newspapers hold their governments accountable, keeping municipal borrowing costs low and ultimately saving local taxpayers money.

Brian Boyer, Taylor D. Nadauld, and Keith Vorkink, Brigham Young University, and Michael S. Weisbach, Ohio State University and NBER

Measuring the performance of private equity investments (buyout and venture) has historically only been possible over long horizons because the IRR on a fund is only observable following the fund's final distribution. Boyer, Nadauld, Vorkink, and Weisbach propose a new approach to evaluating performance using actual prices paid for limited partner shares of funds in secondary markets. They construct indices of buyout and venture capital performance using a proprietary database of secondary market prices between 2006 and 2017. These transaction-based indices exhibit significantly higher betas and volatilities, and lower alphas than NAVbased indices built from Preqin and obtained from Burgiss. There are a number of potential uses for these indices. In particular, they provide a way to track the returns of the buyout and venture capital sectors on a quarter-to-quarter basis and to value illiquid stakes in funds.

Tania Babina, Columbia University, and Sabrina T. Howell, New York University and NBER

How does corporate innovation investment affect employee departures to entrepreneurship (spawning)? Research and development (R&D) investment may generate growth options for the firm or make it a more interesting workplace, which could decrease spawning. Conversely, R&D investment could increase spawning if employees can appropriate some of the new growth options, or if engaging with the R&D process makes them more entrepreneurial. Using U.S. employer-employee matched Census data, Babina and Howell show that R&D investment increases spawning. They identify the causal effect of R&D with changes in federal and state tax incentives. The effect is driven by high-tech parents and by departures to high-growth and venture capital-backed entrepreneurship. Intellectual rather than human capital seems to explain the spawning (i.e., new ideas rather than skills). The effect does not impose observable costs on the parent, leading to the conclusion that entrepreneurial spawning is a source of knowledge spillovers from corporate R&D.

Daniel Paravisini and Juanita Gonzalez-Uribe, London School of Economics

Paravisini and Gonzalez-Uribe estimate the sensitivity of investment to the cost of outside equity for young firms. For estimation, they exploit differences across firms in eligibility to a new tax relief program for individual outside investors in the UK. On average, investment increases 1.6% in response to a 10% drop in the cost of outside equity. This average conceals substantial heterogeneity: 1% of eligible firms issue equity in response to a subsidy that would have doubled investors' returns, implying large outside equity issuance costs for the majority of firms. Conditional on issuing new equity, however, firms invest eight times the issued amount. The results imply a large complementarity between outside equity and non-equity liabilities in young firms.

João Granja, University of Chicago, and Christian Leuz and Raghuram Rajan, University of Chicago and NBER

Granja, Leuz, and Rajan examine the degree to which competition amongst lenders interacts with the cyclicality in lending standards using a simple measure, the average physical distance of their borrowers from their branches. They propose that this novel measure captures the extent to which lenders are willing to stretch their lending portfolio. Consistent with this idea, the researchers find a significant cyclical component in the evolution of lending distances. Distances widen considerably when credit conditions are lax and shorten considerably when credit conditions become tighter. Next, they show that a sharp departure from the trend in distance between banks and borrowers is indicative of increased risk taking. Finally, the researchers provide evidence that as competition in banks' local markets increases, their willingness to make loans at greater distance increases. Since average lending distance is easily measurable, it is potentially a useful measure for bank supervisors.

Despite the prominence of bank equity in theories of banking crises, there is little systematic analysis of the empirical performance of bank equity returns in identifying banking crises and predicting subsequent economic outcomes. To address this gap, Baron, Verner, and Xiong construct a new historical dataset on bank equity returns for 46 countries over the period 1870-2016. They find that bank equity declines provide an informative measure of the occurrence and severity of historical banking crises identified by existing narrative-based approaches. More generally, bank equity declines predict persistent credit contractions and output gaps, after controlling for non-financial equities, even unconditional on banking crises. Consistent with models of constrained intermediaries: 1) the relation between bank equity and future bank credit is asymmetric, with only large negative shocks predicting credit contraction, and 2) bank equity prices tend to fall earlier than non-financial equities at the start of banking crises, especially in the post-war period and advanced economies. Finally, large bank equity declines allow us to refine the existing chronologies of banking crises, in which the researchers uncover a number of forgotten banking crises and remove spurious crises.